With the federal gift and estate tax exemption at $5.45 million for 2016, traditional estate planning may not be helpful for many people. Instead, those whose estates are below the exemption amount are shifting their focus to income tax reduction. High-income taxpayers — particularly those who live in high-income-tax states — may want to consider incomplete nongrantor trusts, which make it possible to reduce or even eliminate state taxes on trust income.
Defining an incomplete nongrantor trust
Generally, trusts are classified either as grantor trusts or nongrantor trusts. In a grantor trust, the “grantor” establishes the trust and retains certain powers over the trust. The grantor is treated as the trust’s owner for income tax purposes and continues to pay taxes on income generated by the trust assets.
In a nongrantor trust, the grantor relinquishes certain controls over the trust so that he or she isn’t considered the owner for income tax purposes. Instead, the trust becomes a separate legal entity, with income tax responsibility shifting to the trust itself. By setting up the trust in a no-income-tax state (typically by having it administered by a trust company located in that state), it’s possible to avoid state income taxes. The grantor is entitled to receive distributions from the trust, usually at a distribution committee’s discretion.
Ordinarily, you make a taxable gift to the trust beneficiaries when you contribute assets to a nongrantor trust. To avoid triggering gift taxes, or using your gift and estate tax exemption, structure the trust as an incomplete nongrantor trust. In other words, relinquish just enough control to ensure nongrantor status, while retaining enough control so that transfers to the trust aren’t considered completed gifts for gift-tax purposes.
In addition to the positives discussed in this article, incomplete nongrantor trusts offer asset protection against creditors’ claims. However, one important caveat: If your home state imposes its income tax on out-of-state trusts based on the grantor’s state of residence, this strategy won’t work.
Using an example
Suppose you live in a state that imposes an 8% income tax and you have a $4 million investment portfolio that earns an 8% annual return, or $320,000 per year, made up of 50% growth, which isn’t currently subject to tax, and 50% currently taxable income. By using the incomplete nongrantor trust strategy described above, you can save $12,800 in taxes (8% of $320,000 × 50%) for the first year, assuming your state doesn’t extend its income tax to out-of-state trusts established by state residents. Presuming similar results, in subsequent years your savings would be compounded.
Assume, for instance, that you reinvest your tax savings in order to grow your portfolio more quickly. Over a 20-year period, an incomplete nongrantor trust would produce a total benefit (state income tax savings plus earnings on reinvested tax savings) of nearly $1.1 million.
Analyzing the benefits
Remember, assets you place in the trust should produce income that the grantor doesn’t need. If the grantor takes money out, trust taxable income could follow to the grantor and be taxed in the grantor’s state of residence.
Incomplete nongrantor trusts aren’t right for everyone. It depends on your particular circumstances and the tax laws in your home state. For example, they’ve been established in favorable tax jurisdictions, such as Delaware, Florida and Nevada.
While this strategy can produce significant state income tax savings, it may increase federal estate and income taxes. Why? Because incomplete gifts remain in your estate for federal estate tax purposes. And nongrantor trusts pay federal income taxes at the highest marginal rate (currently, 39.6%) once income reaches $12,400 (for 2016).
Is it right for you?
To determine whether an incomplete nongrantor trust is right for you, weigh the potential state income tax savings against the potential federal estate and income tax costs. Ask your advisor to conduct a cost-benefit analysis to find out.
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